RCS: Safest Underlying Securities, But Not A Safe Fund

Main Thesis & Background

The purpose of this article is to evaluate the PIMCO Strategic Income Fund (NYSE:RCS) as an investment option at its current market price. RCS is a closed-end fund whose objective is "to generate a level of income that's higher than that generated by high-quality, intermediate-term U.S. debt securities. Its secondary objective is capital appreciation".

I keep my eye on RCS over time because I have often been partial to owning agency MBS. While I have stayed away from this exposure for the most part over the past two years, I am always looking for the right environment to get back in. Doing so may include RCS by extension, since the fund owns over half its underlying securities in that sector. Still, a buy thesis has not materialized in my mind for some time. When summer got underway, I placed a "hold" rating on it - and I was certainly proven right in hindsight:

Given the state of the market in the past few weeks, I am examining all the funds I cover to see if any ratings need adjustment. After consideration, RCS' risk proposition is still concerning to me. Therefore, I do not believe a buy case has materialized, and I will explain why in detail below.

The Premium Is A Non-Starter

The very first metric I always look at for PIMCO CEFs is valuation (i.e. the premium to NAV). The fact of the matter is I can almost stop right here with respect to this particular fund. RCS is sitting with a massive premium above 17%. Trying to justify a bullish argument with this backdrop will be extremely difficult (although I am sure some will try!):

This is just a very poor value for retail investors and I could not find a path for me to recommend this to my followers. A 17% premium sets the fund up for a potentially sharp drop - and that isn't worth the risk in my view. Worse, this premium has actually expanded since my May article when it sat with a 15% premium to NAV.

In summary, RCS is expensive, and even more expensive than it was five months ago despite the market price falling in that time. That shows underlying weakness and is not the type of momentum play I would get behind - but is actually one I would avoid.

Agency MBS Limits Prepayment Risk

A critical attribute of RCS is that this fund is majority agency MBS. This sets it apart from most of the other PIMCO CEFs. Many of the other options are riddled with high yield credit and non-US securities. But agency MBS are widely considered one of the safest corners of the fixed-income market and are generally light in holdings of RCS' sister funds. But the current make-up of RCS shows how important this sector is:

Aside from being safe - in the form of having an implicit guarantee of payment by the federal agency backing the bond - this is also an area that has limited prepayment risk at the moment. While that does limit the ability of RCS to grow its distribution, it will limit the risk of a sudden drop in investment income. The reason being: current mortgage rates have risen dramatically. That makes the attractiveness of refinancing almost zero. After all - who would refinance at a higher rate unless they absolutely have to? The answer is - not many people.

And this isn't just my opinion. As mortgage rates have been on the upswing for most of 2023, refinancing activity has been extremely muted:

The message I am trying to convey here is that this sector should be able to hold its current payouts because households are not refinancing their mortgages. That keeps fixed payments coming in and eliminates a substantial headwind that this sector faces when interest rates are on the decline.

The problem is there are other headwinds to consider. One is that as Americans hunker down with their current mortgages, the ability of this sector to offer higher income streams is challenged. That is likely why RCS is struggling in meeting its current distribution level. Another headwind is that large banks and the Fed have seen their appetite for agency MBS decline. As the Fed shrinks its balance sheet, that is going to require other buyers to step in to make up the difference:

Can other buyers step in? Of course. But have they? Not at the level needed to make up for the Fed and other net sellers. This explains why spreads have widened in the short-term, pressuring current values of the underlying securities and RCS by extension:

This all adds up to a continued "hold" environment. Are there positives to consider? Yes. But are there negatives too? Yes, and big ones. This makes a strong buy or strong sell argument tough to make for the sector and keeps my outlook for RCS stuck in neutral.

Income Metrics Aren't Great

One area that some income-oriented investors may find intriguing is the recent UNII report some PIMCO. In my view, it is a mixed bag - so nothing to rejoice about. But there is some good news. One is that coverage ratios have improved substantially, with some figures over the 100% mark:

This bodes well for maintaining the distribution going forward. But readers are surely aware that these income metrics can be fickle and change dramatically on a month-month basis. So take these figures with a grain of salt.

Furthermore, there is bad news in this report as well. In particular, the UNII balance is a negative $.14/share. That represents almost three months of distributions in arrears and will certainly put pressure on the current income level. So while the improvement in coverage ratios will certainly help the forward outlook, the UNII balance remains a major drag on the fund and poses the heightened risk of a distribution cut. Weigh this carefully before deciding if a CEF with a 17% premium is the correct option for you.

Cost of Leverage Still A Problem

The next topic to consider is the fund's extensive use of leverage. This is a headwind I have discussed many times in a host of articles for the CEFs I cover (not just RCS). The bottom line is that as short-term rates rise, the cost of leverage has increased. And this impacts RCS in a big way because the fund uses quite a bit of reverse repos leverage (essentially short-term borrowing):

At the risk of continuously repeating myself, the simple story here is that the spread earned between the cost of leverage and the income from investments has narrowed (or even become negative) for many sectors. Borrowing costs have soared due to the Fed and longer term income opportunities have been limited due to concerns about future economic growth / a recession. This is central to why RCS may be required to reduce its distribution level and will challenge any buy thesis until that headwind is removed.

High Yield Credit Isn't A Screaming Buy Either

My final topic touches on another area of RCS' portfolio - high yield credit. As mentioned, agency MBS make up a majority of this fund, but it's not the only exposure. RCS also owns government-backed bonds and corporate bonds, with 10% of its exposure in the high yield credit realm. This is a risk-on area, but it is one that investors may be keen to access in order to keep up with inflation.

In fairness, if the Fed is near the end of its rate-hiking path, then entering in to bonds more broadly makes sense. But the challenge is that the Fed isn't done and spreads aren't exactly flashing conviction buy signals. For example, the high yield credit sector is seeing spreads rest near their long-term average. A bad deal? Not necessarily, but its short on value all the same:

What I am driving at is that there isn't any reason to rush in at the moment. RCS is overpriced and some of the underlying sectors (such as high yield credit) are sitting near their long-term averages in terms of valuation. That doesn't mean avoid at all costs - but it does mean that investors can afford to wait, be patient, and buy when the time is right. With respect to this CEF, the time isn't right in my opinion.

Bottom-line

RCS has seen a sharp drop recently and its performance over 2023 leaves much to be desired. Its modest loss since my last review is a trend I expect to continue for the remainder of the year. As a result, I continue to suggest to my followers they avoid this fund and look for other ways to play the agency MBS space if that is a sector they really want to own. Therefore, my "hold" rating will stick for RCS, and I suggest readers approach any positions very carefully at this time and going forward.

Consider the Income Lab